Social media companies’ nonfinancial metrics can send a mixed message.

In November 2013, SEC Chair Mary Jo White questioned whether
investors could project a company’s future potential from “unique
financial or operational metrics” that may not be an indicator of
future profitability. These comments followed Twitter’s initial public
offering (IPO), which raised $1.82 billion through the planned sale of
70 million shares at $26 per share. Twitter’s IPO was, at the time,
the second largest in history for a U.S. internet company despite
Twitter’s disclosure in its first public financial statement that it
lost $79.4 million in 2012 and had not been profitable for the last
three years.

Twitter and other social media and mobile-based companies have
particular ways of capturing their performance levels, whether it be
tweets, Facebook “likes,” Pandora listener hours, visitors, or other
user-based measures. The user data provided in the company’s
management discussion and analysis (MD&A) and elsewhere is not
audited, nor is there any consistency in the way companies determine
these nonfinancial metrics. One social media company may define its
users in a different way than another does, hampering the
comparability of user data across companies and calling into question
the accuracy of the definition and calculation of these nonfinancial metrics.

Social media companies appear to have fast-growing market
capitalizations in common. As of March 31, Twitter boasted a $27.5
billion market capitalization. Facebook’s market capitalization was
$154.5 billion, and LinkedIn had a market capitalization of $23
billion. Facebook’s market cap grew 154% from the quarter ended March
31, 2013, through the quarter ended March 31 of this year. In
comparison, Microsoft’s market capitalization increased 41%, and
General Motors’ increased 45% in the same period.

The actual financial performance of the social media companies,
however, would seem to be at odds with such numbers. Twitter is not
isolated in its history of reporting losses. It would seem investors
are motivated, at least in part, by nonfinancial metrics. Per their
respective Forms 10-Q for the quarter ended March 31, Twitter reported
approximately 255 million monthly “active users,” Facebook reported
1.3 billion monthly “active users,” and LinkedIn reported more than
296 million “registered members.”

The increasing use of nontraditional, nonfinancial metrics as
performance indicators is a growing concern among regulators and
auditors responsible for ensuring the accuracy of financial reporting.
While social media companies may view nonfinancial metrics as
performance indicators, there does not appear to be a connection
between such metrics and profitability, as evidenced in the scatter
plots of financial performance vs. nonfinancial metrics (see Exhibit
3). This potentially could mislead investors. As the
business world continues to depart from traditional brick-and-mortar
companies, the auditing profession may need to reevaluate its current
standards with respect to nonfinancial metrics.

EXAMPLES FROM TOP SOCIAL MEDIA COMPANIES

The six largest public U.S. social media companies in terms of market
capitalization are Facebook, Twitter, LinkedIn, Pandora, Yelp, and
Groupon. All six companies disclose metrics about various aspects of
sizes of users and usage of their services in the MD&A section of
their annual report, Form10-K; quarterly report, Form 10-Q; and
registration statement, Form S-1. The metrics can be categorized in
groups of similar values as shown in Exhibit
1. The data come from the 10-Qs ending March 31, 2014.

Since there are no standard rules for defining these nonfinancial
metrics, companies have taken some, perhaps, unexpected approaches.
For example, Twitter users can have application programs that contact
Twitter for periodic updates, and this type of nonuser interaction is
counted in the daily and monthly active user metrics it reports.
Twitter estimates that 8% of its users have applications with this
capability. In its active user counts, Facebook includes users who
take an action to share content, such as clicking a “like” button on a
third-party website; that is, someone may be counted as an active
Facebook user without actually being on facebook.com. And, as both Twitter and
Facebook generate the vast majority of their revenue through ads, how
“active” an active user is, is not trivial. From an investor
perspective, comparing companies on the same nonfinancial metric has
limitations when the companies define the same term differently.

Devin Knauft, assistant controller at Pandora, said in an interview
that the investor community looks to nonfinancial metrics as leading
indicators of future financial performance and, as such, weighs them
more so than the traditional financial statements. The other social
media companies discussed in this article did not respond to a request
for comment.

The majority of the data and calculations that compose the
nonfinancial metrics come from the reporting companies. In some cases,
there are third-party companies, disclosed in the 10-Q, that collect
user data based on sampling. Pandora uses the services of one such
company, Triton, to quantify reach and usage in order to compare it to
terrestrial radio. Yelp uses Google Analytics to compile and report
its unique visitors but does not include mobile usage in that metric,
according to its 10-Q for the period ended March 31. LinkedIn reports
unique visitors and page views based on data provided by comScore.
Social media companies recognize and disclose that metrics can be
inaccurate due to user behavior or technical issues as noted in Exhibit 2.

FINANCIAL PERFORMANCE MEASURES VS. NONFINANCIAL PERFORMANCE MEASURES

Are social media companies’ nonfinancial metrics indicators of
financial performance? FASB set forth in its Conceptual Framework that
“the objective of general purpose external financial reporting is to
provide information that is useful to present and potential investors
and creditors and others in making investment, credit, and similar
resource allocation decisions.” Preparers of financial statements are
required to adhere to the standards set forth by FASB to ensure
comparability and consistency in financial reporting. Consequently,
the financial statements have traditionally been the vehicle through
which a company can communicate its performance to the market, and
that performance should ideally be reflected in the company’s share price.

Many social media companies enjoy sizable market capitalizations that
are apparently not supported by traditional, audited financial
measures but rather by unaudited nonfinancial metrics. However, these
nonfinancial metrics may not correlate with financial success. The
increasing user activity reported in the unaudited MD&A has not
necessarily translated into profits reported within a company’s
audited financial statements. Exhibit
3 highlights that no relationship exists, with the
exception of Facebook, between each company’s income (loss) from
operations and the primary nonfinancial metric it reports to indicate
its level of user engagement.

AUTHORITATIVE GUIDANCE

The MD&A provides a comprehensive overview of the company’s
business and financial condition. The SEC’s basic and overriding
requirement of the MD&A is to “provide such other information that
the registrant believes to be necessary to an understanding of its
financial condition, changes in financial condition and results of
operations.” It should not merely be a narrative outlining the
financial statements, but rather it should contribute to the overall
financial and operational performance of the company through
management’s unique perspective.

The SEC provided further interpretive guidance on the MD&A
stating that “companies should identify and discuss key performance
indicators, including nonfinancial performance indicators, that their
management uses to manage the business and that would be material to
investors.” The guidance also states that when “there is no commonly
accepted method of calculating a particular non-financial metric, it
should provide an explanation of its calculation to promote
comparability across companies within the industry.”

According to the PCAOB, the auditor’s responsibility with respect to
information in a document such as the Forms 10-K and 10-Q, “does not
extend beyond the financial information identified in his report, and
the auditor has no obligation to perform any procedures to corroborate
other information contained in a document.” The auditor should review
the other information and “consider whether such information, or the
manner of its presentation, is materially inconsistent with
information, or the manner of its presentation, appearing in the
financial statements.”

Companies may, but are not required to, engage audit firms to perform
an attest engagement with respect to the MD&A. This engagement is
a review or examination rather than a full audit of the information
presented. For example, a review consists principally of applying
analytical procedures and making inquiries of persons responsible for
financial, accounting, and operational matters. With respect to
nonfinancial data, the auditor conducting a review must consider
whether the definitions used by management for this nonfinancial data
are reasonable and if suitable criteria such as industry standards
exist.

The Forms 10-K, 10-Q, and S-1 are client-submitted documents, and the
auditor is not responsible for verifying all the information that is
disclosed. The MD&A portion of these filings, therefore, provides
information that is, for the most part, unaudited. In the required
audit, the auditor has no responsibility to verify nonfinancial
measures nor any financial information not already disclosed in the
audited financial statements. The nonfinancial metrics reported by
social media companies and other industries do not undergo an audit to
validate the accuracy of their definitions or calculations. While
companies can engage the audit firms to perform a review or
examination of the MD&A, this is not required and generally not
conducted. Even with a review or examination in place, the auditor
cannot gain assurance as to the validity of the nonfinancial metrics
without some guidance from industry standards.

WHAT'S NEXT?

The growth in the social media industry brings with it new challenges
in financial and nonfinancial reporting. While the companies boast
huge market capitalizations, their financial performance,
traditionally viewed as the driver of a company’s stock price, does
not seem to be in line with these figures. There does not appear to be
a relationship between the income a company is reporting and its
market capitalization. Rather, social media companies are relying on
nonfinancial metrics to serve as performance indicators. The
nonfinancial metrics are fraught with inconsistencies and potential
inaccuracies, and neither the data, nor the procedures used to collect
the data, nor the calculations undergo an audit to validate the
accuracy of their definitions or calculations.

Management has the right and duty to report its performance from its
unique perspective within the MD&A. With continued growth in the
reporting of nonfinancial metrics, the audit profession may need to
reevaluate its current requirements related to the MD&A. The
existing audit model is not equipped to opine on companies that place
more emphasis on nonfinancial metrics than on traditional financial
measures to express their performance, nor can it provide assurance to
investors relying on such metrics.

While companies can engage the audit firms to perform a review or
examination of the MD&A, this is not required and generally not
conducted. Even with such an engagement in place, the auditor cannot
gain assurance as to the validity of the nonfinancial metrics without
some guidance from industry standards. With the SEC’s guidance, the
social media industry should look to develop some standardization of
its nonfinancial metrics to allow for a possible review and some form
of verification by an external auditor.

At the very least, auditors may want to consider disclosing their
responsibility, or lack thereof, with respect to nonfinancial metrics
reported in the company’s MD&A. A disclaimer stating that the
information does not undergo an audit or other attest engagement may
highlight to investors that this information is purely a
representation by management. The disclaimer could include any
reservations the auditor has about the accuracy of the data and their
connection to future profitability or market value. This issue is of
growing concern to regulators, and investors should be aware of the
dichotomy that can exist between unaudited nonfinancial metrics and
audited financial measures as clearly evidenced in the social media industry.

EXECUTIVE SUMMARY

User data compiled by social media companies is not
audited, and there is little consistency in the way companies
determine these nonfinancial metrics (such as Facebook “likes”).

The use of nontraditional, nonfinancial metrics as performance
indicators is a potential concern for regulators and auditors
responsible for ensuring the accuracy of financial reporting.

Social media companies may view nonfinancial metrics
as performance indicators, but there does not appear to be a clear
link between such metrics and profitability.

The SEC provided guidance that companies should identify and
discuss key performance indicators, including nonfinancial
ones that would be material to investors. The guidance also states
that when no common method exists for calculating a specific metric,
the company should provide an explanation of its calculation.

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